It is the nature of capital markets to have capital demand outstrip supply. This is an interesting juxtaposition, given that cash could likely be considered the world’s most abundant commodity. Because growth demand is ever-present, capital demand will always outstrip supply, regardless of how much money the Fed is able to print.
Luckily, new rules allow for greater access to investors than ever before. Greater access can mean increasing the size of your real estate transaction is more viable than it was even just a few years ago.
But while bigger deals can present greater opportunities for outsized returns in non-traditional transactions, there are also downside risks to going outside your internal network of investors to source capital.
Deal Size & Leverage
It goes without saying that sourcing outside capital can significantly increase the size of the transaction you intend to undertake. This is further multiplied if you intend to use leverage to finance your real estate acquisition. After all, doing a large acquisition is just as easy (and sometimes easier) as doing a large one, it’s all a matter of sourcing capital.
Because the typical capital structure of most real estate deals includes 25% or more equity, the larger the deal size, the greater requirement for equity infusion, but it also means you can pile on larger amounts of leverage to increase the size of subsequent transactions as you pay down your debt.
But leverage cuts both ways. Increasing the size of your deal, increases the size of the levered risk attached to real estate transaction. And if outside investors are in-play, the capital at risk is more than just your own. If a larger deal goes sideways due to unforeseen events, outside investors may come seeking blood. And if you went “all-in” yourself, squeezing the blood out of a stone may be impossible, but it will still inflict massive pain.
Whenever you bring in outside investors you not only have additional cooks at the table, you also run the risk of losing control. Of course, giving away complete control is wholly dependent on how you structure your real estate offering.
The weight of a real estate buyer’s ownership will be based on two critical elements. First, the weighted share of equity investment compared to other investors. Second, the commitment the said equity investors have in a deal. For instance, are there personal guarantees that may tie up other personal assets to the deal? Stringent qualitative requirements for certain other equity investors may force them to require greater equity control when it comes to executing the final deal structure. Issuer beware.
Risks of Regulation D
Bringing in outside investors will typically require some type of securities exemption to ensure proper compliance with the law. In doing so, you may wish to even expand your offering further via general solicitation and through Regulation D 506(c).
As part of the JOBS Act legislation of 2012, Reg D 506(c) (aka Title II) allowed issuers to generally solicit their offering but precludes non-accredited investors from participating. Ask any good real estate investment bank and you will find that expanding your investor pool via Title II has additional risks as well.
First, is the inclusion of unknown investors. Anytime an issuer brings unknown investors into a transaction there is the potential for phishing for opportunities to make litigious claims against the issuer. If you do not have a good personal relationship and know the character of each investor in a given real estate transaction, then there is a higher likelihood of a later lawsuit, whether things go completely sideways or simply not quite as advertised.
Secondly, there are higher costs of raising capital through Title II offerings. General solicitation itself describes a process that would include advertising your deal across various platforms and forums online. Additionally, such offerings also will require state notice filings wherein each state regulator where investors in your real estate deal are located will be required to both notice file and also pay the state securities regulator fee. In short, the cost of your equity capital using broad-based advertising via Regulation D 506(c) is going to cost more.
Regardless of whether you are seeking capital in a residential or commercial property, a real estate development project or some type of distressed rehab, there are numerous ways to effectively increase the size and scope of your deal by reeling in outside investors. Luckily if you play within the guise of the law, there are many expanded methods to be employed for sourcing more capital for your next big project. However, maintaining an understanding of the keen risks associated with sourcing capital outside your investor pool will help you remain out of regulatory hot water.
But, if you play it right, outside investors can help you scale your real estate investments like no other method available.